By Chris Gillick
The easy money in a trade that hedge funds have feasted upon during the past 12 months might soon be over. With the spread between the yields of two-year and 10-year Treasury notes at an all-time high and the yield curve at record steepness, something’s got to give.
The standby bread-and-butter trade of “buy the two, sell the 10,” referring to buying two-year U.S. Treasury notes and simultaneously selling their 10-year peers, was basically a can’t-lose prospect in 2009. By taking advantage of falling two-year yields and rising 10-year ones—a phenomenon known as a curve steepener—funds minted profits as the 2-10 spread doubled from 144 basis points at the start of last year to 288 in December. The spread sat at 277 bps at press time.
But according to a research report issued by Bank of America-Merrill Lynch in mid-January, hedge funds have been unwinding the trade, paring their net long exposure in two-year note futures to approximately $9.1 billion, down from $19.5 billion at the end of 2009. Since then, they have been increasing their net notional short exposure in 10-year note futures to $15 billion from $8.5 billion at the end of 2009. Selling pressure on both ends of the curve has prevented its shape from changing much in the last six months, with the 2-10 spread sitting in a range between 240 and 280 basis points. The 2-10 trade is the second most popular macro trade by hedge funds next to gold, according to the report. Funds that trade the yield curve mostly fall under the banner of commodity trading advisor, global macro, and relative value strategies. According to an interest rates salesperson covering hedge funds for an investment bank, every fund that actively trades macro strategies is involved in the 2-10 trade. These include but are not limited to traditional powerhouses Brevan Howard Asset Management, Moore Capital Management, Soros Fund Management, and Tudor Investment Corp.
The 2-10 is considered more a macro trade than a relative value one, functioning as an indicator of the economy and Fed policy as opposed to a mechanism of exploiting an inherent mispricing.
“The dramatic and consistent steepening of the 2-10 spread has been greatly influenced by the economic outlook,” says Jon Williams, head of U.S. markets management at fixed-income trading platform Tradeweb Markets. At the same time, yields on the long end of the curve have been under selling pressure due to inflationary concerns related to growing confidence about a U.S. economic recovery coupled with the deficit impact of the massive borrowing done to finance that recovery.”
The Pacific Investment Management Company’s Bill Gross expressed this very sentiment in early January, announcing that he favored debt issued by Germany rather than the U.S., as the latter poses more sovereign risk in the long term, which in turn would demand a higher yield. On the short end of the curve, the return of risk and the lack of urgency for safety have led to some unwinding of two-years on the long side.
One CTA following this line of thinking is Justin Balas, director of research of the Welton Global Directional Portfolio."This is becoming more of a one-sided trade,” says Balas, referring to traders’ focus on shorting the 10-year.
The most common venue for executing the 2-10 trade is in the over-the-counter cash market. But in order to ensure that the trade is immune to interest rate sensitivity, it must be what is called duration neutral. Today it’s anything but. As of press time, the duration ratio for the 2-10 stands at roughly 4:1. Therefore, if funds wish to put on the popular steepener trade, they must buy four times as many two-years as they sell 10-years.
On the other hand, if traders bet that the yield curve will flatten, they must sell four times as many two-years as they buy 10-years. However, if funds put on a flattener trade, they must pay seven basis points a month in carry charges, making it difficult to hold on a longer-term basis.
Funds can also use the interest rate swap market to bet on a steepening. Instead of making two simple cash trades—buying two-year notes and selling 10-year notes—traders can leverage up by buying two separate swaps after posting initial margin—receiving two-year fixed/paying three-month Libor and paying 10-year fixed/receiving three-month Libor. Tiger Management’s Julian Robertson made this very swap trade famous in late 2008 when the spread went from 144 before Lehman’s bankruptcy to a high of 262 in November of that year. Also nailing the late-2008 steepening was Prologue Capital, earning 10% for their main fund in the fourth quarter of 2008. Prologue used mostly cash and a combination of eurodollar futures and Fed funds derivatives contracts on its short-end long positions.
Additionally, equity-focused hedge funds which seek exposure without using the credit markets can use the customizable exotic options market, paying an up-front premium for the 2-10 spread to reach a certain level by a certain date in exchange for a payout, limiting their downside to the premium paid.
Not all trading of the yield curve is about the 2-10. In 2009, fixed-income funds, including Prologue, put on a successful relative-value trade along the curve involving long bonds. At the nadir of the market in March 2009, Prologue portfolio manager Tom McGlade began shorting the current 10-year note while buying a duration-neutral equivalent of off-the-run Treasury bonds maturing in November 2021 with an 8% coupon, betting that the yield spread between the two would narrow. The trade has paid off, as the yield spread between 10-years and 8s-of-November-2021 has moved from a 70 basis point discount to 29, a result of the Fed’s quantitative easing program buying, credit spreads contracting and risk trades running their course.
Profits aside, the outlook remains tenuous. “Going into 2009, we knew the Fed couldn’t cut anymore and wouldn’t raise rates for at least a year, so the predictive outlook was much easier,” says McGlade, referring to the Fed’s current near-zero interest rate policy. “Now we know that the Fed has to raise rates at some point, but no one knows when.”
Tradeweb’s Williams believes, like many in the industry do, that the Fed will continue to be on hold for a while. When the Fed does raise rates, two-year yields will likely increase, causing the curve to flatten.
But McGlade adds that funds are being careful about the 2-10 flattener because the cost to hold the trade is so high.
“No one wants to be too early on this one,” he says.
